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Rational exuberance

The stock market's at record highs. Economic growth is the weakest in four years. What gives?

By Chris Isidore, CNNMoney.com senior writer

May 8 2007: 4:49 PM EDT

NEW YORK (CNNMoney.com) -- The last time stocks were setting records the way Wall Street is now was way back in March of 2000, and we all remember how that ended.

A recession and a brutal bear market were just around the corner.

That's why it's easy for some investors to be worried now, even with the Dow Jones industrial average on its best run in 80 years. At the same time the S&P 500, a broader measure of blue-chip stocks watched more closely by Wall Street pros, is nearing its record high as well.

But while the stock market's partying, economic growth is the weakest it's been in four years. Two key parts of the economy - housing and auto sales - are already in recession. Home prices are posting historic declines and auto sales have been tanking. And another pillar of economic growth, business spending, has been weak.

Mix in record high gasoline prices even before the summer driving season has begun, and it makes sense to wonder if Wall Street has become disconnected from Main Street, and whether stocks are poised for another big fall. One like the 2000 crash that led the S&P 500 to lose almost half its value over the next 2-1/2 years.

But don't assume that even slower economic growth will stop the bulls.

"There is no rule that says the market and the economy need to be on the same sleep cycle," said David Kelly, economic advisor for Putnam Investments. "We've had enormous growth in corporate profits that justify a higher market than we have today."

Kelly and some other economists say there's a big difference this time that could keep stocks going strong even if economic growth is lackluster. They note that stock prices are modest compared to earnings, as corporate profits have been soaring in recent years but stocks have yet to catch up.

They say if anything, stock investors are showing a rational exuberance this time around - rather than what former Federal Reserve Chairman Alan Greenspan famously called the "irrational exuberance" of investors back in the mid-1990s.

Kelly noted that in six of the 10 recessions since World War II, the Dow Jones industrial average has been able to post gains even as the nation's economy went into reverse.

And given today's environment, he and some other economists argue that even with the blue-chip gauges near record highs,stock prices are fairly valued, or even undervalued, given corporate profits.

Jaseem Hasib, senior research analyst for earnings tracker Thomson Financial, said current forecasts are for just 3.3 percent earnings growth in the second quarter, down from the new upwardly revised first-quarter estimate of 8.1 percent.

The full-year forecast is for profit growth of 7 percent, but that's expected to jump back to 11.5 percent for 2008.

But even with the more modest forecasts, the S&P 500 is trading at 15.5 times earnings estimates for the coming 12 months, up just a bit from 15.3 three months ago, and near the long-term average of 15.4, since January 1985.

All that market valuation numbers are well below the 19.5 ratio in March 2000, about the time of the last market peak, or the record 25.5 ratio in July 1999.

"Compared to what the P/E levels were during the tech boom, there's level-headedness," said Hasib. "Investors are not getting ahead of themselves."

Of course, some argue that weakness in housing and the underlying economy, with a wide trade gap and a negative savings rate,will soon bring on a recession that no stock market rally will be able to ride out.

"There certainly isn't as big a stock bubble as there was in 2000. That was just ridiculous," said Peter Schiff, President of Euro Pacific Capital, a brokerage firm specializing in overseas investments. "But the U.S. economy is in far worse shape today, so what we're about to go through with the recession will be far worse. The earnings are going to collapse."

Yet others say that's underestimating U.S. corporations.

Steven Wieting, U.S. economist at Citigroup, argues that stock prices still have some ways to go to catch up with the earnings growth achieved the last few years.

Corporate earnings have soared 115 percent since the fourth quarter of 2001, when the last recession ended, he said, even though the S&P 500 is up only 35 percent over that same period.

"I think this outperformance of U.S. stocks versus the U.S. economy has been a long time in coming," he said.

Wieting said that even though the first quarter will apparently end its record 14-quarter streak of double-digit earnings growth by S&P 500 companies, the majority of companies in the index are still seeing profit growth north of 10 percent.

Corporate profits have gotten fat as companies became more efficient, cutting costs and boosting productivity. And with labor costs in check, revenue growth of 5 to 12 percent or so has flowed more quickly to the bottom line, lifting profits to the biggest on record relative to the economy.

Wieting said with a bigger chunk of revenue for the nation's largest companies coming from overseas sales - 26.5 percent at last estimate - the slowdown in the U.S. economy shouldn't take as big a bite from earnings as it once would have.

"It just looked to me we didn't need a lot of economic growth to be optimistic on equities," said Wieting.